The Euro Debacle

OP-ED COLUMNIST
Legends of the Fail
By PAUL KRUGMAN
Published: November 10, 2011

This is the way the euro ends — not with a bang but with bunga bunga. Not long ago, European leaders were insisting that Greece could and should stay on the euro while paying its debts in full. Now, with Italy falling off a cliff, it’s hard to see how the euro can survive at all.

But what’s the meaning of the eurodebacle? As always happens when disaster strikes, there’s a rush by ideologues to claim that the disaster vindicates their views. So it’s time to start debunking.

First things first: The attempt to create a common European currency was one of those ideas that cut across the usual ideological lines. It was cheered on by American right-wingers, who saw it as the next best thing to a revived gold standard, and by Britain’s left, which saw it as a big step toward a social-democratic Europe. But it was opposed by British conservatives, who also saw it as a step toward a social-democratic Europe. And it was questioned by American liberals, who worried — rightly, I’d say (but then I would, wouldn’t I?) — about what would happen if countries couldn’t use monetary and fiscal policy to fight recessions.

So now that the euro project is on the rocks, what lessons should we draw?

I’ve been hearing two claims, both false: that Europe’s woes reflect the failure of welfare states in general, and that Europe’s crisis makes the case for immediate fiscal austerity in the United States.

The assertion that Europe’s crisis proves that the welfare state doesn’t work comes from many Republicans. For example, Mitt Romney has accused President Obama of taking his inspiration from European “socialist democrats” and asserted that “Europe isn’t working in Europe.” The idea, presumably, is that the crisis countries are in trouble because they’re groaning under the burden of high government spending. But the facts say otherwise.

It’s true that all European countries have more generous social benefits — including universal health care — and higher government spending than America does. But the nations now in crisis don’t have bigger welfare states than the nations doing well — if anything, the correlation runs the other way. Sweden, with its famously high benefits, is a star performer, one of the few countries whose G.D.P. is now higher than it was before the crisis. Meanwhile, before the crisis, “social expenditure” — spending on welfare-state programs — was lower, as a percentage of national income, in all of the nations now in trouble than in Germany, let alone Sweden.

Oh, and Canada, which has universal health care and much more generous aid to the poor than the United States, has weathered the crisis better than we have.

The euro crisis, then, says nothing about the sustainability of the welfare state. But does it make the case for belt-tightening in a depressed economy?

You hear that claim all the time. America, we’re told, had better slash spending right away or we’ll end up like Greece or Italy. Again, however, the facts tell a different story.

First, if you look around the world you see that the big determining factor for interest rates isn’t the level of government debt but whether a government borrows in its own currency. Japan is much more deeply in debt than Italy, but the interest rate on long-term Japanese bonds is only about 1 percent to Italy’s 7 percent. Britain’s fiscal prospects look worse than Spain’s, but Britain can borrow at just a bit over 2 percent, while Spain is paying almost 6 percent.

What has happened, it turns out, is that by going on the euro, Spain and Italy in effect reduced themselves to the status of third-world countries that have to borrow in someone else’s currency, with all the loss of flexibility that implies. In particular, since euro-area countries can’t print money even in an emergency, they’re subject to funding disruptions in a way that nations that kept their own currencies aren’t — and the result is what you see right now. America, which borrows in dollars, doesn’t have that problem.

The other thing you need to know is that in the face of the current crisis, austerity has been a failure everywhere it has been tried: no country with significant debts has managed to slash its way back into the good graces of the financial markets. For example, Ireland is the good boy of Europe, having responded to its debt problems with savage austerity that has driven its unemployment rate to 14 percent. Yet the interest rate on Irish bonds is still above 8 percent — worse than Italy.

The moral of the story, then, is to beware of ideologues who are trying to hijack the European crisis on behalf of their agendas. If we listen to those ideologues, all we’ll end up doing is making our own problems — which are different from Europe’s, but arguably just as severe — even worse.

"The moral of the story, then, is to beware of ideologues who are trying to hijack the European crisis on behalf of their agendas. If we listen to those ideologues, all we’ll end up doing is making our own problems — which are different from Europe’s, but arguably just as severe — even worse."

PARIS — As the bets that European banks made on United States mortgage investments went bust a few years ago, bankers piled into what they saw as a safe refuge: bonds issued by countries in Europe’s seemingly ironclad monetary union.

Now, the political and financial crisis engulfing the Continent has turned much of that European sovereign debt into the latest distressed asset, sending tremors through global financial markets not seen since the demise of the investment bank Lehman Brothers more than three years ago.

This week, shortly after European leaders formally conceded that Greece could not pay its debts and forced banks to accept losses, the shock waves reached Italy, the third-largest economy in the euro zone after France and Germany. And despite frantic efforts by politicians to contain the damage, market analysts said that France, one of the strongest countries in the euro zone, may soon feel the impact.

“When people started buying more European sovereign debt, there was not a cloud in the sky,” said Yannis Stournaras, director of the Foundation for Economic and Industrial Research, based in Athens. Now, he said, “This crisis is going to last because the perceptions of risk have changed dramatically.”

European banks face tens and possibly hundreds of billions of dollars in losses on loans to nations that use the euro. Worried about even greater losses if the crisis worsens, the banks have been scrambling to reduce their holdings of an investment that, like triple-A-rated subprime mortgage bonds, was once thought to be bulletproof.

The French bank Société Générale, for instance, this week marked down 333 million euros of its Greek sovereign debt holdings and in October slashed its exposure to that country to 575 million euros, from 2.4 billion euros at the beginning of 2011. Another French bank, BNP Paribas, has cut its holdings of Italian government debt 40 percent since July, to 12.2 billion euros.

How European sovereign debt became the new subprime is a story with many culprits, including governments thatborrowed beyond their means, regulators who permitted banks to treat the bonds as risk-free and investors who for too long did not make much of a distinction between the bonds of troubled economies like Greece and Italy and those issued by the rock-solid Germany.

Banks had further incentive to overlook the perils of individual euro zone countries because of the fees they earned for underwriting sovereign debt sold to other investors. Since 2005, several dozen banks in Europe and the United States have earned $1.1 billion in fees from selling bonds for European governments, according to Thomson Reuters and Freeman Consulting Services.

Like other investors, banks clung for a long time to the seemingly inviolable belief that all the countries using the euro would make good on their debts. For years, Greek and Italian bonds did not pay much more than German ones, but banks were always hungry to chase even a fraction of additional profit. For much of the last decade, they bought the higher-yield bonds, ignoring the growing political and fiscal problems of those countries as well as other peripheral euro zone nations like Ireland, Spain and Portugal.

Regulators bear much of the responsibility. Before 1999, when Europe forged its monetary union, regulators permitted banks to treat as risk-free the debt of any country that belonged to the Organization for Economic Cooperation and Development, a club of developed nations that includes the United States and most of Europe.

“There was encouragement from European authorities for banks to load up on more debt, because it was seen as safe,” said Nicolas Véron, a senior fellow at Bruegel, a research firm in Brussels. “In hindsight, it was unwise risk management.”

Some regulators realized that allowing banks to set aside no capital for sovereign defaults could be a problem and moved to address it in a 2006 accord known as Basel 2. They mandated that big, complex banks use their own models to determine if individual countries were at risk and hold some capital against them. But the European Union never enforced the stiffer regime. And amid the subprime mortgage crisis, Europe’s regulators added to the problem by demanding that banks hold more safe assets, much of it sovereign debt.

As a result, banks were not discouraged from placing their most liquid assets “into the worst possible government debt,” Achim Kassow, a former Commerzbank board member, wrote in a study published by the European Parliament.

Quinn
New Providence, NJ
November 11th, 2011
1:05 pm
What has been playing out in the Euro zone is that formerly sovereign nations are not in control of their destinies, let alone their economies. As a result, they must take the medicine prescribed by others. I liken this situation to going to the doctor and before you have described your symptoms, he has written out a prescription. No need to waste time hearing the symptoms and figuring out the cause of the illness - he's seen it a thousand times before. This kind of quackery is being foisted on country after country: slash spending, cut benefits, reduce debt, pay back the lenders. Then we wonder why economies are not growing and there is a crisis of consumer and business confidence. Much of the current weakness in the world economy has been self-induced.

Ashland, OR
November 11th, 2011
2:04 am
It's a shame that the Euro experiment is not working out, but the ground rules were never flexible enough to allow less prosperous countries to succeed with a currency largely pegged to the economies of Germany and France. With the right fixes, the Euro could possibly be saved, but Europe's current focus on austerity and balancing budgets won't let that happen.

The only lesson I see for the U.S. is that austerity is an economic dead end. Japan tried austerity in the 1990's, and it set them back to an extent that they still haven't fully recovered. Other countries have been put through the austerity wringer by the World Bank and the IMF. The current push for asuterity in the U.S. in the face of a weak economy and high jobless rate is pure folly. The economy needs to be put back on its feet before any austerity measures are put in place. Fears of runaway inflation or of foreigners selling dollars in a state of panic seem to be unfounded, based on the dollar's current strength, so why is there such a panic over the budget at the present time?

I'll tell you why. The Republicans want to use "austerity" to frighten people into thinking that some terrible calamity will happen (see above) unless the budget is balanced quickly. But they also know that the deficit could be reduced greatly by ending the Bush tax cuts, closing of corporate loopholes, and ending the very low capital gains taxes on Wall Street incomes. The Republicans aren't about to let that happen. They also are opposed to cutting defense spending, trimming agricultural and oil subsides, or cutting any other program that amounts to welfare for the rich. Instead, their goal is to slash away at the social safety net: social security, Medicare, Medicaid, food stamps, earned income tax credit, children's lunch programs, etc. Given their way, the country would return to the pre-New Deal days of Coolidge and Hoover, which led to massive income inequality (like today) and to the Great Depression.

9.
Doug Terry
Maryland, USA
November 11th, 2011
2:04 am
As usual with highly political arguments, one may use the problems of Europe to prove almost anything. Why is the hard right not suggesting that the extreme difficulties over there represent a failure of capitalism? Of course, that wouldn't fit the narrative needed.

It is wrong, also, to try to think of Europe as essentially one entity, all socialist and all failing. Greece is a special case. Its economy, its business and social practices have not been updated to the 20th century, much less this one. It is, underneath, a rigid society where business opportunities and professional mobility are tightly controlled by long held, and unchanging, practices.

Clearly, it is possible to tip the balance between productive, income generating work and, on the other hand, government jobs and social programs. There is, in everything, a point where too much of a good thing comes into play. The fact that much of Europe has a vastly better underpinnings of support for its entire society might be making recovery from over indebtedness more difficult, but too much debt is, in essence, just that, not something else, not something slapped on top to prove a point.

Europe is being used as an example to scare Americans, instead of allowing us to look at how close we came to the brink of a world wide economic collapse and, most importantly, who in our society took us there. In the main, it is the same group of people now harping on Europe.

In many cases, we wind up spending as much or more than Europe does on social programs, we just do it differently. Emergency room and hospital expenses rather than preventative care. Prisons and efforts to help those who survive mass killings rather than jobs and mental health care. Emergency medical services and police officers rather than housing programs and training for the homeless.

A nation is like a ship except that we can't easily throw over those who are in trouble or cause trouble. One way or another, we pay.

Nouriel Roubinihttp://www.economonitor.com/nouriel/...-have-options/
The announcement of the most recent EZ rescue package (acceptance of a bigger haircut for Greek private creditors, the recapitalization of EZ banks and the use of guarantees and financial leverage in the hope of preventing Italy and Spain losing market access) led to markets rallying for a day as the tail risk of a disorderly situation in the EZ, temporarily, diminished. By the next day, Italian yields and spreads were still close to their high, serving as a reminder—as we argued in “The Last Shot on Goal: Will Eurozone Leaders Succeed in Ending the Crisis?,” co-authored with Megan Greene—that the EZ’s fundamental problems will not be resolved by this trio of policy actions.

To put the latest package in context, we need to first assess the fundamental problems facing the EZ and the potential scenarios for the monetary union.

EZ Flow Problems

The EZ suffers from both stock and flow problems, which are related to each other. The flow problems were and/or are:

Large fiscal and current account deficits in most members of the EZ periphery (Greece, Ireland, Portugal, Cyprus, Spain and Italy);
Economic weakness, manifesting itself in renewed near recession or outright recession and weak actual and potential growth;
The periphery’s long-term loss of competitiveness, driven by three factors: Loss of export market share to emerging markets (EMs) in traditional labor-intensive low-valued-added sectors; real appreciation, driven by wages growing more than productivity since the inception of the EZ; and the relative strength of the value of the euro in the past decade.
EZ Stock Problems

The stock problems are the large and possibly unsustainable stock of liabilities of: The government (in most of the periphery with the exception of Spain); the private non-financial sector (mostly in Spain, Ireland and Portugal); the banking and financial system (in most of the periphery); and the country (external debt), especially in Greece, Spain, Portugal, Cyprus and Ireland.

Stock vulnerabilities are the result of flow imbalances: A big fiscal deficit results in a growing and large stock of public debt (Greece, Italy, Ireland, Cyprus, Portugal) and in a large stock of foreign debt when private sector savings-investment imbalances are also large; a wide current account deficit—whether driven by private sector imbalances (like in Spain and Ireland) or public sector ones (Greece, Cyprus, Portugal)—leads to a build-up of foreign debt. In some cases, the excesses started in the private sector (housing boom and then bust in Ireland and Spain); so, initially it was a buildup of private debts and of foreign debts driven by large current account deficits. In other cases, the excesses started in the public sector (Greece, Italy, Portugal, Cyprus), leading to a large stock of public debt and of foreign debt—via current account deficits—in the subset of countries with fragile savings-investment imbalances in their private sectors (Greece, Portugal, Cyprus).

Until recently, Italy had a public debt problem but not current account and foreign debt problems as the high savings of the household sector prevented the fiscal deficit from turning into a current account deficit. But now, the sharp fall in private savings has led to the emergence of a current account deficit even there. In Spain and Ireland, the flow and stock imbalances started in the private sector leading to large current account deficits and foreign debts, but once the Spanish and Irish housing sectors went bust and resulted in sharp fiscal deficits—in part, due to the socialization of private losses—the ensuing rise in public debt created a sovereign debt sustainability problem.

Recent Policy Actions Start to Deal With Some Stock Vulnerabilities

The recent EZ package starts to deal with some—but by no means all—of the stock imbalances in the EZ periphery. First, public debt—in some (Greece) but not all of the countries where it is unsustainable (Portugal, Ireland, Cyprus, Italy)—will be reduced (50% haircut on private creditors, though the July plan will have to be completely scrapped, and the new details are lacking at this point). Second, the excessive amount of debt relative to the equity/capital of EZ banks will be partly addressed—to prevent insolvency—by recapitalizing EZ banks (both in the periphery and the core). These banks suffer from low capital ratios and potential erosion of their capital through losses, given exposures to sovereigns, busted real estate and rising non-performing loans as a result of the growing recession. But the capital needs of EZ banks, given these tail-risk losses, are much larger than the €100 billion of recapitalization needs that the EZ has identified. Third, illiquidity—of banks and sovereigns—risks turning illiquidity into insolvency as self-fulfilling bad equilibria of runs on short-term liabilities of banks and governments are possible. Thus, the ECB’s full allotment policy would prevent such a run on bank liabilities in principle only for banks that are illiquid but solvent, but in practice even possibly for insolvent banks.

For sovereigns that have lost market credibility—and whose spreads could blow to an unsustainable level—“catalytic finance” to use the traditional IMF terminology (see my book “Bailouts vs. Bail-Ins”) or the “big bazooka” of the financial equivalent of Powell’s doctrine of “overwhelming force” is necessary to provide time and financing for the flow adjustment—fiscal and structural—to restore market confidence and reduce spreads to sustainable levels. In each case, assumptions need to be made about whether a country is a) illiquid but solvent given financing to prevent loss of market access, time and enough adjustment/austerity (possibly Italy and Spain); b) illiquid and insolvent (Greece, clearly); or c) illiquid and near insolvent and already needing conditional financing given that market access has already been lost (Portugal, Ireland and Cyprus).

But even if Italy and Spain were illiquid and solvent given time, financing and adjustment, the big bazooka that the EZ needs to backstop banks and sovereigns in the periphery is at least €2 trillion and possibly €3 trillion rather than the fuzzy €1 trillion that the EZ vaguely committed to at the recent summit. So, on all three counts, the recent EZ plan falls short of addressing the stock problems of highly indebted sovereigns, the capital needs of EZ banks and the liquidity needs of EZ banks and sovereigns; it also does little or nothing to restore competitiveness and growth in the short run.

Critical Role of Flow Factors in Resolving Stock Sustainability Issues

To make stocks sustainable, it is crucially important to address flow imbalances, for several reasons. First of all, without economic growth, you have a dual problem: a) The socio-political backlash against fiscal austerity and reforms becomes overwhelming as no society can accept year after year of economic contraction to deal with its imbalances; b) more importantly, to attain sustainability, flow deficits (fiscal and current account) and excessive debt stocks (private and public, domestic and foreign) need to be stabilized and reduced, but if output keeps on falling, such deficit and debt ratios keep on rising to unsustainable levels.

Second, restoring growth is also important because, without growth, absolute fiscal deficits become larger rather than smaller (given automatic stabilizers). Third, restoring external competitiveness is key as that loss of competitiveness led—in the first place—to current account deficits and the accumulation of foreign debt and to lower economic growth as the trade balance detracts from GDP growth when it is in a large and growing deficit. So, unless growth and external competitiveness are restored, flow imbalances (fiscal and current account deficits) persist and stabilizing domestic and external deficits becomes “mission impossible.” Finally, note that, unless growth and competitiveness are restored, even dealing with stock problems via debt reduction will not work as flow deficits (fiscal and current account) will continue and, eventually, even reduced debt ratios will rise again if the denominator of the debt ratio (debt to GDP), i.e. GDP, keeps on falling. Growth also matters as credit risk—measured by real interest rates on public, private and external debt, which measures the default risk—will be higher the lower the economic growth rate. So, for any given debt level, a lower GDP growth rate that leads to a higher credit spread makes those debt dynamics more unsustainable (as sustainability depends on the differential between real interest rates and growth rates times the initial debt ratio).

While the issue of fiscal deficits and public debt has been overemphasized in the recent policy debate about the problems of the EZ, one should not underestimate the role of external—current account—imbalances. These imbalances are now becoming unsustainable as the “sudden stop” and “reversal of private capital inflows” that the periphery has suffered implies that such deficits are now not financeable in the absence of official finance. These deficits are the result of savings-investment imbalances in both the private (Spain, Ireland, Portugal) and public sectors (Greece, Portugal, Cyprus, Italy); they are also the result of the real appreciation of these countries following a decade of declining export market share, the growth of wages in excess of productivity growth and the strength of the euro. Some of these deficits are now cyclically lower given that the collapse of output/demand has led to a fall in imports. But, on a structural basis, unless the real appreciation is reversed, the restoration of growth to its potential level would result in the resumption of large—and now not financeable—external deficits.

So, the modest reduction in current account deficits in the periphery that has been seen since 2009 is deceptive: It doesn’t—for the most part—reflect an improvement in competitiveness; it is only the result of a severe and persistent recession. Real depreciation is required to restore such competiveness while ensuring sustained economic growth. An inability to restore competitiveness and thus growth would eventually undermine the monetary union as private creditors are now—after a sudden stop—unwilling to finance such deficits. So, eliminating the external current account deficit is as critical to restoring debt sustainability as reducing flow fiscal deficits. And fiscal deficits are not the only explanation of the external deficits as real appreciation and loss of competitiveness are as important, if not more important, than fiscal imbalances, in explaining such external imbalances.

The Recent EZ Package Does Little or Nothing to Restore, in the Short Term, Growth and Competitiveness, Which Are the Key to Sustainability

The latest economic data—such as the EZ PMIs—strongly suggest that the EZ—not just the periphery, but also the core—are falling back into a recession. This is very clear in the periphery where some countries never got out of their first 2008 recession, while the others are plunging back into recession after a very moderate recovery. But even in the core of the EZ, the latest data suggest that a recession is looming.

The recent EZ package (a bigger Greek haircut, bank recaps and a levered European Financial Stability Facility (EFSF), together with more fiscal austerity and a push toward structural reforms) does nothing to restore competitiveness and growth in the short run. In fact, it actually exacerbates the risk of a deeper and longer recession. Fiscal austerity is necessary to prevent a fiscal train wreck, but, in the short run (as recent IMF studies suggest), raising taxes, reducing transfer payments and cutting government spending (even inefficient/unproductive expenditure) has a negative effect on economic growth, as it reduces aggregate demand and disposable income. Moreover, even structural reforms that will eventually boost growth via higher productivity growth have a short-run negative effect: You need to fire unproductive public employees; you need to fire workers in weak firms and sectors; you need to shut down unprofitable firms in declining sectors; you need to move labor and capital from declining sectors to new sectors in which the country may have a comparative advantage. This all takes time and, in the absence of a rapid real depreciation, what are the sectors in which a periphery country has a new comparative advantage? Even necessary structural reforms—like fiscal austerity—reduce output and GDP in the short run before they have beneficial medium-term effects on growth.

To restore growth and competitiveness: The ECB would have to rapidly reverse its policy hikes, sharply reduce policy rates toward zero and do more quantitative and credit easing; the value of the euro would have to sharply fall toward parity with the U.S. dollar; and the core of the EZ would have to implement significant fiscal stimulus if the periphery is forced into necessary but contractionary fiscal austerity (which will have a short-term drag on growth).

Options for Dealing with Stock and Flow Problems

Stock imbalances—large and potentially unsustainable liabilities—can be addressed in multiple ways: a) high economic growth can heal most wounds, especially debt wounds given that fast growth in the denominator of the debt ratio (i.e. GDP) can lead over time to a lowering of debt ratios; b) low spending and higher savings in the private and public sectors can lead to lower fiscal deficits and lower current account deficits (lower flow imbalances) that, over time, reduce the stocks of public and external debt relative to GDP; c) inflation and/or forms of financial repression can reduce the real value of debts; the same can occur with unexpected depreciation of the currency if the liabilities are in a domestic currency; d) debts can be reduced via debt restructurings and reductions, including the conversion of debt into equity. The last option is key: If growth remains anemic in the EZ; if savings lead to the paradox of thrift (a more severe short-term recession) and if monetization, inflation or devaluations are not pursued by the ECB, the only way to deal with excessive private and public debts becomes some orderly or disorderly reduction of such debts and/or their conversion into equity.

Flow imbalances are more difficult to resolve as they imply a reduction of fiscal and current account deficits that are consistent with sustainable growth and with the restoration of competitiveness, which requires real depreciation. To reduce external current account deficits—the key to restoring competitiveness and growth—you need both decreases in expenditure (private and public) and expenditure-switching through a real depreciation. Such real depreciation can occur in four ways: a) a nominal depreciation of the euro large enough to lead to a sharp real depreciation in the periphery; b) structural reforms that increase productivity growth while keeping a lid on wage growth below productivity growth and thus reduce unit labor costs over time; c) real depreciation via deflation—a cumulative persistent fall in prices and wages that achieves a sharp real depreciation; and d) exit from the monetary union and return to a national currency that leads to a nominal and real depreciation. The key issue here is—as we will discuss in detail below—that achieving the real depreciation via route a) is unlikely, as there are many reasons why the euro will not weaken enough; getting it via b) may take way too long—a decade or more—when the sudden stop requires a rapid turnaround of the external deficit; achieving it via c) may also take too long and would be associated with a persistent recession, while leading to massive balance-sheet effects; thus the d) option—exit from EZ—becomes the only available one if the other three are not feasible/desirable.

Additionally, if growth and competitiveness are restored in short order, this is the best way—on top of decreased expenditure via fiscal austerity—to reduce both the fiscal and current account imbalances as well as the relative ones (i.e. as a share of GDP). In other terms, fiscal austerity and structural reforms eventually restore growth and productivity, but they are, in the short run, recessionary. Thus, other macro policies are needed to restore growth, which is critical to make the adjustment politically and financially feasible. Therefore, macro policies consistent with a rapid return to economic growth are the key to resolving flow problems.

BUDAPEST | Thu Nov 10, 2011 5:23pm EST
Nov 10 (Reuters) - Europeans could use a little cheering up this week. One man who is trying to do that is George Soros. He knows his way around a currency crisis, of course, and he isn't usually accused of being a Pollyanna. Soros thinks it is not too late to save Europe and the euro -- but he warns that time is running out and that Europe's leaders must fundamentally change their strategy to succeed.

Let's start with the bad news. "Right now, the crisis has hit a new high, because there's an unresolved government crisis in Greece and in Italy," Soros said this week from Warsaw..

"There is also a looming worsening of the financial crisis because all the efforts to leverage the EFSF have run into legal or technical difficulties," he said, referring to the European Financial Stability Facility, the bailout fund for the euro zone.

"That means that currently Europe has no ring fence against a possible Greek default, and that is what is pushing the market into a renewed panic," Soros said. "I expect the market to fall into despair and panic and I expect that to get worse."

Despair may indeed be the right emotion, if you accept Soros's prediction of what will happen if European leaders don't get ahead of the markets: "This crisis is potentially bigger than the crash of 2008, because we have survived the crash of 2008 and we have not yet survived this one. There is a danger if they get it wrong, then you have a financial meltdown," he told me in Budapest last week. "If there is a disorderly default in Greece, and the rest of the euro zone has not been insulated from contagion, then you could have a meltdown not only of the Greek financial system, but of the European and in fact the global financial system because we are so interconnected."

So far, so dire. But Soros has two ideas that should perk you up. One is about the bazooka, and one is about the most important woman in the world.

The bazooka is the financial weapon Europe has created to defend ailing European economies from the skeptical traders who are betting against them. To end the crisis, Europe needs a bazooka big enough to convince the markets that making a wager against Frankfurt will be futile -- and expensive.

Until now, the story of this financial crisis is one of European leaders consistently being one step behind the markets: bringing a fist to a knife fight, then a knife to the gunfight -- and never bringing out the bazooka. Conventional wisdom -- and the verdict of the markets this week -- is that the European Financial Stability Facility war chest of 440 billion euros, or $600 billion, is a continuation of this pattern of insufficiency.

Soros disagrees: "It actually has the bazooka in its hand, provided it uses it in the right way."

To do that, Soros said, Europe must first acknowledge what its bazooka is too small to achieve: rescue Europe's faltering members directly. The bailout fund, he said, "was designed as a way of providing guarantees on government bonds, but for that purpose it is clearly inadequate. It cannot be stretched to cover Italy and Spain."

But the bailout fund is big enough, Soros thinks, to save Europe in a different way. "It needs to be used to guarantee the banking system," he said. "That would create a lender of last resort, which is currently lacking."

The bailout fund, he continued, could take the solvency risk, which is beyond the legal mandate of the European Central Bank. "And for that," he said, "there is plenty of money." Thus shored up, the banks would be able to buy the high-yielding government debt of the European countries that are currently struggling to find lenders.

Banks would be encouraged to hold their liquidity in government bonds, Soros said, which they could sell to the European Central Bank at any moment. "So, it is the equivalent of cash, and it would yield more than cash, therefore they would hold it," Soros said. "That would allow countries like Italy and Spain during this crisis period to borrow at negligible cost."

His plan, Soros said, would make Italy's debt "sustainable, because the ECB has any amount of money for the purpose of providing liquidity. At the same time, it would not violate the law against the ECB directly financing the governments."

The Soros plan is essentially a way to get around Europe's fundamental economic flaw: It has a single currency, but no lender of last resort. "It's a trick, but a trick that would work."

The European crisis has metastasized because Germany has been adamant about blocking precisely this sort of trick. The second reason for Soros's relative optimism is his conviction that Germany and its leader, Chancellor Angela Merkel -- the aforementioned most important woman in the world -- have recently had a crucial change of heart.

"It is entirely in the hands of Germany," Soros said. "Angela Merkel's attitude has changed. She recognizes that the euro is in mortal danger and she is willing to risk her political future to save it. I think she recognizes that Germany has caused the crisis to get out of control, and she is now determined to correct that."

Merkel is very good at getting what she wants, so fans of Europe and the euro should be somewhat reassured by Soros's verdict. But only somewhat. Soros is a persuasive salesman of his plan to rescue Europe, but his most telling remark comes when I ask him what he would do if he were still actively trading.

"I would be sitting on the fence like everybody else, because the situation is so uncertain."

Energy was the department he forgot. Would he scrap the department’s 17 national labs, including such world-class facilities as Los Alamos, N.M., Oak Ridge, Tenn., or — there’s that primary coming up — Aiken, S.C.?
I’m not accusing Perry of wanting to do any of these things because I don’t believe he has given them a moment of thought. And that’s the problem for conservatives. Their movement has been overtaken by a quite literally MINDLESS OPPOSITION to government. Perry, correctly, thought he had a winning sound bite, had he managed to blurt it out, because if you just say you want to scrap government departments (and three is a nice, round number), many conservatives will cheer without asking questions.